1. Field of the Invention
The present invention relates to an over the counter traded product and a system of offset or contingent trading of instruments which links an OTC marketplace with a futures exchange via an electronic interface. Particularly, the present invention is directed to a system wherein one contract is automatically exchanged for another contract on a related commodity.
2. Description of Related Art
Trading of financial derivatives contracts (e.g., futures, options on futures, forwards, swaps, options on swaps, etc.) for physical commodities, natural resources and financial instruments (all generally referred to as commodities) is common in both the over-the-counter (“OTC”) and the futures markets. Many of the commodities traded in an OTC market have similar corresponding futures or options contracts traded on futures exchanges. This is for the simple reason that there is a pricing relationship between the futures contract, the underlying asset on which it is based, and a related OTC derivative. This is particularly the case in crude oil markets where there is a price relationship between the physical wet crude oil and related derivatives. For example, Brent futures, which trade on, for example, the ICE Futures (“ICE Futures”) is linked to a 21 day Brent, Forties and Oseburg (“BFO”) forward contract which then turns into Dated Brent, as traded on, for example, the IntercontintentalExchange, Inc. (“ICE”). Also because of the linkages between different crudes, there are pricing relationships between different types of crude oil—e.g., there is a price correlation between U.S. West Texas Intermediate and the North Sea Brent crude oils, and between North Sea Brent crude oils and other oil markets, such as Dubai.
Besides the difference in the type of contract, regulatory supervision, and trading method (open out-cry, voice brokered, auction, electronic, etc.), OTC markets and futures markets differ in that futures markets are typically anonymous and always clear trades through a central counterparty, whereas OTC markets may be traded on a bilateral or cleared basis. This difference is often significant because bilaterally settled transactions require that the counterparties (e.g., buyers and sellers) accept each other's credit worthiness in relation to contract performance, whereas in a cleared market, the clearing firm manages collateral for contract performance on behalf of the counterparties. From a purely performance risk perspective (e.g., payment/collection or delivery/receipt of the asset), cleared contracts are typically preferred, especially where counterparties are largely unfamiliar with each other. In addition, there may be more liquidity in a particular contract on a particular base commodity (e.g., crude oil, natural gas, electricity, etc.) in either an OTC or futures market, and the investor or principal would typically rather trade in a market having more liquidity because it gives wider access to price discovery, potential counterparties, market information, quantities, and for contracts requiring physical delivery, delivery dates. In addition, in markets that are less liquid, there are potentially fewer counterparties with whom to trade, and the possibility that counterparties will be unacceptable from a contract performance, and consequently risk perspective, is increased. Alternatively, investors or principals that manage open positions up to and throughout the delivery process may prefer the guaranteed contract performance that clearing provides for a derivative prior to delivery, but upon fulfilling the terms of the contract, may choose the selectivity that the OTC markets provide in terms of potential counterparties and the potential synergies that non-anonymous delivery offer.
To take advantage of the OTC market and the futures markets trading in similar base commodities, a manual process of initiating and offsetting open positions from one method of contract performance to another is currently the norm—usually by completing a form provided by the exchange, and then submitting to the relevant exchange (via phone, fax, online, etc.). For example, suppose a party holds a long position in a relatively illiquid OTC commodity, such as a Dubai crude oil swap, which is a derivative contract based on a particular type of oil. The party wishes to convert that Dubai swap position into a position in a more liquid commodity, or a cleared commodity (because it no longer wishes to maintain contract performance risk for its counterparty to the trade). In this case, the party could convert the Dubai swap to a futures contract in Brent, which is another derivative of an oil commodity that typically trades at a price level, or differential, with respect to the Dubai crude oil.
According to the prior art, the counterparties would consummate an offsetting or contingent trade for the Dubai swap in the OTC market, then manually contact a clearing firm to submit the corresponding futures contract for registration on a futures exchange. The clearing firm submits a trade as an “exchange for physical” (EFP) or “exchange for swap” (EFS), depending on the settlement type of contract being switched into or out of, and the futures exchange matches the two sides and advertises the off-exchange trade to the futures market to notify that an EFP or EFS has taken place. The futures exchange may request documentation from the counterparties as evidence to the corresponding OTC trade to ensure that there has been no abuse under the futures exchange rules. This method works, but is inefficient. It also leads to potential risk in that there is risk of human error in agreeing to the terms of the trade, confirming with other counterparties, and completing a form for the relevant exchange. There is also a risk that the relevant exchange may refuse to accept the trade (typically because it either does not reflect market value, or for other regulatory reasons).
What is needed to make the process more efficient and to provide effective risk management and straight-through processing for counterparties and reduce operational risk is an automated EFS or EFP process that links an electronic OTC market and an electronic futures exchange and automatically generates an exchange futures position. A further need is a system which provides near real-time audit and market supervision capabilities for futures exchanges. Another need is a system that reduces operational risk for counterparties and provides near immediate straight-through processing into back office and risk management systems. Another need is a system that provides enhanced transparency for the exchanges for EFPs and EFSs.